Net worth is a calculation that immediately defines an individual’s or household’s financial position. It’s only one piece of a greater financial puzzle, but it’s an important piece. The concept of wealth relies mostly on net worth, which contrasts with the concept of poverty, which is generally related to a different financial equation, income.
Wealth however, is relative, while net worth is absolute. Place someone with a net worth of $50,000 in the middle of New York City, and she’s likely to have problems living the same lifestyle as those around her. Place the same individual with the same net worth in rural Kentucky, and the wealth will go further. Visit a developing nation elsewhere on the globe and $50,000 will feel like a million bucks.
In the Naked With Cash series, readers are sharing their net worth every month. And before that, I shared my financial reports publicly since 2003. Readers who stayed with me since the beginning — and there were many — followed my journey from a net worth of $21,000 in July 2003 (a few years after I began trying to improve my financial situation) to a “non-business” net worth of $373,000 in December 2011. (If I had included my business net worth, which would have consisted of income earned from my business but not distributed to me personally and the proceeds from the sale of that business, the figure would have been significantly higher.)
As a net worth calculation is valid only for one specific moment of time, seeing net worth change over time provides some context to a net worth calculation and offers more insight into one’s financial condition.
How do you calculate net worth?
The equation is Wn = A – L. Wn is your net worth, the value you want to calculate. A is the value of all of your assets. L is the value of all your liabilities. Being able to calculate your net worth depends on understanding what your assets and liabilities are.
Assets include everything you own. That means everything from bank accounts in your name to the value of your furniture and linens.
Liabilities include everything you owe. Your credit card debt is a liability, but so are the taxes you will owe on your investments when you sell them.
Add up the value of all your assets, add up the value of all your liabilities, subtract your liabilities from your assets, and the result is your net worth. It’s a fairly simple calculation, but people often get in trouble when trying to determine the value of their assets and liabilities. It’s not always straightforward. In fact, most of the time, people don’t include all their assets and liabilities. When you want to track your financial progress from month to month, sometimes it makes sense to exclude certain factors, and settle for a “modified net worth” equation.
When I reported my net worth each month, and when the Naked With Cash participants do the same, the number on the bottom line is a “modified net worth,” not a true net worth, because there is room for some customization of the equation. We don’t need to show every asset and every liability to get a continuing picture of financial progress.
How does a house fit into net worth?
The house one lives in is a curious asset. It’s so curious that some people refuse to believe it is in fact an asset. This seems to have started with a popular book promoter and seminar salesperson, Robert Kiyosaki, who in his influential book declared that houses are liabilities. It’s blasphemy! Regardless of whether you have a mortgage, a house is a physical object you own. Liabilities are not physical objects, at least when it comes to liabilities on a balance sheet (the net worth equation).
The word “liability” can have a broader meaning: anything that has the potential of causing you trouble. In that sense, children are liabilities. Responsibilities are liabilities. Performing your own electrical maintenance is a liability. Your neighbor’s dog is a liability. Therefore, your house is a liability. But don’t include it as a liability on your balance sheet, because your house is an asset when it comes to your finances.
There is absolutely no argument otherwise. I’m always happy to entertain dissenting views on Consumerism Commentary, and I’ve been proven wrong on issues before, but your house is an asset.
So now that we know your house is an asset, with absolutely no room for disagreement, why is a minority of financial experts so adamant that houses are liabilities? If they are, they’re not talking about the net worth equation. They simply want to point out that owning a house is a money-draining endeavor. There are two categories of assets that can appear on your net worth statement: income-producing assets, and expense-producing assets. In Kiyosaki’s infinite wisdom, he has completely confused his legion of fans by calling the first category “assets” and the second category “liabilities.”
It’s like a famous chef deciding to call unhealthy meats “meats” and unhealthy meats “vegetables,” and then inspiring a rather loud community of followers, after heavy promotion on The Food Network, to believe that healthy meats are actually vegetables.
Where does a mortgage fit into net worth?
Your mortgage, if you have one, is a liability. The remaining balance of your mortgage loan is included on the liability side of a balance sheet. It, along with all the other amounts of money you owe someone else, is subtracted from the total value of your assets to determine your net worth.
If you take the value of your house (more on determining this value) and subtract the balance of you mortgage, you have your house equity. That’s the same calculation for any secured loan, or a loan that is “attached” to an asset. But your equity does not need to be included separately in your net worth, because you’re already accounting for the value of your house on the asset side and the balance of your mortgage on the liability side.
The idea is that by paying your mortgage bill each month, your equity increases. Some mortgage loans are structured in such a way that your equity would only increase if the underlying value of the house increases. That’s the case with interest-only mortgages. For a long period of time, borrowers who have interest-only mortgages never get to the point where they’re decreasing the principal balance of the loan.
Why not just leave your house and mortgage off your balance sheet?
If you rent the space where you live, you generally don’t include your future rent payments as a liability, even though they are, in one sense. Furthermore, the increasing or decreasing value of your house has little relationship to your financial activities on a day-to-day basis. Your net worth could be increasing every year due to your living in a developing neighborhood, but this could be masking financial problems with credit and debt, or other decisions with money that will eventually get you into trouble.
What good is your net worth bottom line if it reflects positive increases during a period where your checking account is dealing with overdrafts and your credit card balances are increasing?
This is why it’s important to look at more than just the bottom line of a net worth statement. When you see an increase in net worth from month to month, look at the details. Did he receive a windfall inheritance? Is he changing his house’s value every month based on an estimate? Did she pay off her debt but completely deplete her emergency fund? Context and details are important in a net worth calculation. Otherwise, it’s just a number that doesn’t explain much about one’s financial situation.
But how do you come up with the right value for your house? I’ll look at some methods for determining your house’s value for the purpose of net worth in a future article.